Business Entity Selection: Choosing the Right Structure

Why Business Structure Matters

There's no universally "best" structure. The right choice depends on your business type, income level, risk profile, and goals.

Entity Types Overview

Sole Proprietorship

What it is: You and your business are legally the same. Default for single-person businesses.

Formation: None required. You're automatically a sole prop when you start business activities.

Taxation:

• Business income/loss on Schedule C
• Subject to self-employment tax
• Pass-through to personal return

Liability: None. You're personally liable for all business debts and obligations.

Best for:

• Very small, low-risk businesses
• Testing business ideas
• Low-liability services
• First-year freelancers

Limitations:

• No liability protection
• All income subject to SE tax
• May appear less professional
• Harder to bring on partners

Limited Liability Company (LLC)

What it is: A hybrid entity providing liability protection with flexible taxation.

Formation:

• File Articles of Organization with state
• Create Operating Agreement (especially multi-member)
• Costs $50-500 depending on state
• Annual fees in many states

Taxation (default):

• Single-member: Disregarded, taxed like sole prop (Schedule C)
• Multi-member: Partnership (Form 1065)
• Can elect S-Corp or C-Corp taxation

Liability:

• Personal assets protected from business liabilities
• Must maintain separation (no commingling funds)
• "Piercing the corporate veil" possible if not properly maintained

Best for:

• Any business with liability concerns
• Freelancers and consultants
• Real estate investments
• Small businesses with growth potential

S-Corporation

What it is: A tax election (not a separate entity type) that can apply to LLCs or corporations.

Formation:

• Form LLC or Corporation first
• File Form 2553 with IRS for S-Corp election
• Meet requirements (US shareholders, one class of stock, etc.)

Taxation:

• Pass-through (no double taxation)
• Must pay "reasonable salary" to owner-employees
• Remaining profit as distributions
• Only salary subject to payroll tax
• This is the main benefit

Liability: Depends on underlying entity (LLC or Corp).

Requirements:

• Reasonable salary must be paid
• Payroll processing required
• More complex returns (Form 1120-S)
• Strict operational requirements

Best for:

• Profitable businesses ($70k+ net income)
• Owner-operators who want to reduce SE tax
• Service businesses with consistent income

C-Corporation

What it is: A separate legal entity, distinct from owners.

Formation:

• File Articles of Incorporation with state
• Create bylaws
• Issue stock
• Hold organizational meeting

Taxation:

• Entity pays corporate tax (21% federal)
• Dividends taxed again to shareholders (double taxation)
• Can retain earnings at corporate rate
• More deduction options

Liability: Strong protection; shareholders not personally liable.

Best for:

• Venture-backed startups
• Businesses planning to go public
• Companies retaining significant earnings
• Situations where double taxation isn't an issue

Comparing Structures

*Unless S-Corp election made

The S-Corp Tax Advantage

How It Works

Without S-Corp (Sole Prop or default LLC):

• $150,000 net profit
• All $150,000 subject to self-employment tax (15.3%)
• SE tax: ~$21,000

With S-Corp election:

• $150,000 net profit
• Pay $80,000 as W-2 salary
• $70,000 as S-Corp distribution
• Payroll tax only on salary: ~$12,200
• Savings: ~$8,800

When S-Corp Makes Sense

Consider S-Corp when:

• Net profit exceeds $70,000-100,000
• Business is stable with predictable income
• You're comfortable with payroll administration
• Tax savings exceed additional costs

Don't rush into S-Corp if:

• Income is uncertain
• Just starting out
• Profit below $50,000
• Hate administrative complexity

S-Corp Costs and Requirements

Ongoing costs:

• Payroll service: $500-2,000/year
• Tax return preparation: $800-2,500/year
• Possible bookkeeping: $2,400-6,000/year

Requirements:

• Run payroll (at least for yourself)
• File Form 1120-S annually
• Maintain corporate formalities
• Reasonable salary documentation

Break-even analysis: If S-Corp costs $3,000/year extra but saves $8,000 in taxes, it makes sense.

Making the Decision

Year 1: Start Simple

For most new businesses:

1. Start as sole proprietor
2. Open business bank account
3. Track income and expenses
4. File Schedule C

Why:

• No upfront cost
• See if business is viable
• Can always form LLC later
• Learn the basics first

When to Form LLC

Form LLC when:

• Business generates consistent income
• You have liability concerns
• Working with clients who expect it
• Have assets worth protecting

LLC formation process:

1. Choose state (usually where you live/operate)
2. File Articles of Organization
3. Get EIN from IRS
4. Create Operating Agreement
5. Open business bank account

Cost: $50-500 + possible registered agent ($50-150/year)

When to Elect S-Corp

Elect S-Corp when:

• Net profit consistently $70k+
• Understand payroll requirements
• Have accountant to help navigate
• Ready for additional administration

S-Corp election process:

1. Have LLC or Corporation in place
2. File Form 2553 with IRS
3. Can be done by March 15 for current year
4. Or within 75 days of entity formation

When to Consider C-Corp

C-Corp makes sense for:

• Seeking venture capital
• Planning IPO
• Want to retain significant earnings at lower rate
• Complex ownership structures

For most small businesses, C-Corp is overkill.

State Considerations

Formation State

Generally form in your home state:

• Where you operate
• Where you live
• Avoid complications

Delaware/Nevada/Wyoming:

• Often advertised for privacy/protection
• Usually not worth it for small business
• May have to register in home state anyway
• Just adds cost and complexity

State Taxes

Be aware of:

• State income tax on business
• Franchise taxes
• Annual report fees
• Sales tax obligations

California example:

• $800 minimum franchise tax for LLCs
• Adds to cost analysis

Multi-Member Considerations

Partnerships

When you have partners:

• Operating agreement is CRITICAL
• Define profit sharing
• Define decision-making
• Define exit procedures
• Get a lawyer involved

Partnership taxation:

• Pass-through to partners
• Each partner gets K-1
• Each pays taxes on their share

Protecting Relationships

Working with Professionals

When to Involve a Lawyer

Get legal help for:

• Multi-member LLC formation
• Operating agreement drafting
• Partnership agreements
• Contract review
• Any liability concerns

Cost: $500-2,500 for LLC formation with operating agreement

When to Involve an Accountant

Get accounting help for:

• S-Corp election decision
• Reasonable salary determination
• Tax planning strategies
• Annual filing

Cost: $500-2,500 for election analysis and filing

DIY vs. Professional Formation

DIY may work for:

• Single-member LLC
• Simple business
• Willing to research
• Low-risk situation

Use a professional for:

• Partners involved
• Significant assets
• Liability concerns
• S-Corp election
• Any uncertainty

Common Mistakes

Mistake 1: Choosing Based on Name

"I need an Inc. to look professional." Reality: LLC is fine for 99% of small businesses.

Mistake 2: S-Corp Too Early

"I want to save on taxes from day one." Reality: Costs may exceed savings at low income.

Mistake 3: Delaware for No Reason

"I heard Delaware is best for businesses." Reality: Usually just adds cost for small businesses.

Mistake 4: Ignoring Ongoing Requirements

Forming entity but not maintaining it properly. Reality: Can lose liability protection.

Mistake 5: No Operating Agreement

Multi-member LLC without written agreement. Reality: Recipe for disaster when disagreements arise.

Entity Selection Flowchart

The Bottom Line

Start simple—most businesses should begin as sole proprietorships. Form an LLC when you have consistent income and assets worth protecting. Consider S-Corp election when profit exceeds $70k and savings outweigh administrative costs. C-Corp is rarely needed for small businesses. Whatever you choose, maintain proper separation between personal and business finances to preserve liability protection. Work with professionals for complex situations, partnerships, and S-Corp elections. The right structure balances protection, tax efficiency, and administrative burden for your specific situation.